Article co-written with Gildas Michaud (Responsible Credit Analysis – Triple Jump)
The coming year is going to be more complicated than most economists and analysts anticipate. The optimism built around the “Trump reflation” has fogged the realities. Indeed, from an economic point of view, the world is in a better shape than at the beginning of 2016. According to the IMF, the global GDP is expected to grow by 3.4% in 2017 and inflation will pick up to 1.8% from 0.8% the previous year.
However, first of all, this growth is not uniform. The emerging economies should grow two times more than the developed world (4.6% versus 1.8%). Secondly, we begin this New Year with more uncertainties than the previous one. The lack of clarity from the new U.S. administration, the personality of Donald Trump, a busy political agenda in Europe, Brexit’s implications or a new balance of power in the Middle-East are just some potential factors which could change the forecasts dramatically. We will not mention systematic risk, which from our point of view will continue to be ignored by the markets in 2017. The greatest among all these remains the Chinese threat that has completely vanished from market radars. China is cumulating several potentially systemic issues, including the property market slowdown, regulatory framework for shadow banking or a massive corporate debt.
- The Investment themes
- A fade and disappointing “Trumponic effect.”
Paradoxically, the election of Donald Trump brought Keynes back in the U.S. economy policy. Indeed, the new President is planning massive investment and infrastructures measures to boost the economy. The budgetary policy weapon is going to replace eight years of an expansionist monetary policy. Not mentioning the fact that the new administration would need the agreement of a non-friendly Congress, such policy raises some questions. How is this going to be financed: public investment or taxes stimulus for the private sector? Can the U.S. economy afford such programs that by essence have to be large enough to impact the country? Even if such programs were to be implemented, it would take at least twelve to eighteen months to see some results materializing.
Secondly, it sounds controversial to launch a Keynesian program when the U.S. economy is experimenting a period of full employment and when at the same time, the new administration plans to stop immigration and expulse millions of migrants. The real problem of the U.S. labour market has not been to create jobs; it is the quality of the jobs created that is problematic. Under the Obama administration, despite a low level of unemployment, the mean average salary has decreased, and in some industries, the U.S. economy is lacking high-skilled employees.
- A relatively low-interest rate environment
At the last meeting, the FOMC increased interest rates to 0.75%, and it moved for 2017 the rate path projections to three hikes from two. If the Fed has to follow its agenda, the interest rate would be at 1.50% at the end of 2017, a level still historically low. But the Yellen’s prediction has been a source of disappointment in the past, four hikes was planned in December 2015. Indeed, the economic picture remains precarious. The increase in GDP in Q3 was due in large part to the positive impact of inventories and exports. The last Non-Farm Payrolls was below expectations and not the reflection of a booming economy.
In Europe, the ECB announced an extension of asset purchases until at least the end of 2017. The new stimulus will take holdings to at least 2.28 trillion euros, or twice as much as was initially envisaged when broad-based QE started in early 2015. The accommodative line is maintained, and a normalization of interest rates remains a sweet dream. In Japan and UK, for different reasons, an increase in interest rates will be out of the question in 2017.
In the emerging world, the situation is not homogenous. Admittedly, a large external vulnerability or a large dollar debt burdens (for instance, Turkey and Egypt) will force some Central Banks to follow the Fed and hike interest rates. But there is scope for central banks across Emerging Asia and Emerging Europe to keep rates at record lows. Moreover, in the large commodity producers where inflation is expecting to fall further, policymakers will have room for loosening monetary conditions in 2017.
- An uncertain geopolitical environment
As we do not believe in a “global trade war” and a hard Brexit would impact only the UK, the primary sources of instability will come from Europe and the Middle-East.
3.1 The European Political Agenda
The Brexit and the election of Donald Trump highlighted the risk of protectionism and isolationism. The speed of this world has changed the business model of a lot of industries, with sometimes dramatic consequences for some part of the population. Some politicians have blamed Globalization and people sanctioned establishment voting for populist parties.
The same phenomena could happen again in The Netherlands, France, Germany and likely Italy in 2017. The French case is probably the most worrying. At the opposite of Germany, France did not change the structure of its economy. Under Chancellor Schroeder, Germany modernized its labour market, – cuts in the social welfare system, lowered taxes, and reformed regulations on employment and payment -, and built the foundations to face 21st Century challenges.
France did not do the job. Worse, each new government before being elected promised to make reforms, but they never did. Traditional parties lost all credibility in front of a population lost in translation. At the two last regional elections, the extreme-right party of Marine Le Pen came in first place. In the case of victory, she plans to organize a referendum to bring France out of the euro area.
3.2 A Middle-East in movement
The Middle-East has been historically a source of instability. But in 2016, crucial events happen implying long-term and uncertain consequences.
In Saudi Arabia, the death of King Abdallah and the collapse of oil prices have pushed the Kingdom to drastic changes. Due to the fall of oil price, Saudi Arabia lost close to $160 Bn in revenues in a matter of 18 months, forcing the country to rise for the first time in its history $17.5 billion on the international bond market. The Kingdom is embarked on a challenging plan to change the face on the Saudi Arabia.
The Iran come back on the international scene and the emergence of an 80 million people economy will affect the region in a positive or in a negative way. The normalization of the relation between the Shiite Iran and the Sunnite Saudi Arabia is the key factor for the stabilization of the region. It will dictate the evolution of the situation in Syria, Iraq, Lebanon, Bahrain and Yemen. It also will have a huge impact on the different terrorist movements that acted in Europe in 2015 and 2016, and could drive oil prices lower or higher.
3.3 The Russian’s temptation
The victory of Assad in Syria signed the victory of the Russian diplomacy, and the implementation of its commodity policy. After all, the Syrian conflict was “a commodity war” in relation with the Syrian Gazoduc project. However, with in background, the Ukrainian case and after the election of the most pro-Russian American President that the world has ever seen, Europe is alone on the Russian front. The development coming from this new situation could impact the Eastern-Europe economy and the Euro area.
- Uncertain outlook for commodity prices
Commodity prices remain difficult to predict. 2016 rebalancing in oil supply was not sufficient, and the market is still not in balance. In addition to unpredictable geopolitical factors which are difficult to measure, the implementation of the agreement on OPEC production freeze remains uncertain, while the development of U.S. shale production is still a question mark. Copper prices, also one of the primary drivers of Frontier markets, have dropped dramatically in the last years, driven by a decrease in demand from the Chinese construction sector.
- The implications for 2017
- A soft normalisation of the U.S. interest-rates policy and an expansionist budgetary policy would limit U.S. Dollar appreciation. It will be a positive factor for Emerging and Frontier markets, particularly in South America.
- A Deception of the “reflation” will create a gap between consumer confidence expectations/impact of the Trump program and as a consequence, a lower US Equity market than anticipated. At the beginning of the year, the consensus forecast for the U.S. economic was for real U.S. GDP to grow by 2.4% (the realised number is probably 1.6%). The analysts expected EPS growth of 7% (1% is more likely).
- QE program in Europe will weigh on the Euro, and it will bring liquidity on European equity. A weak euro will be favourable to company exporting outside the euro area.
- The low-interest rate environment, particularly in the developed economy, will move liquidity to Emergent and frontier fixed incomes markets.
- The high level of uncertainties will push asset allocation to more diversification and long-term investment. Asset-classes underweighted will be increased in the portfolios (Inflation-linked Bond, Emerging and Frontier equity and FI).
- Commodity prices trend remains one of the biggest uncertainties for 2017. The geopolitical aspect is always difficult to measure. However, with an improvement of the world growth, price stability or a moderate increase are the most likely scenario.
- Still long equity
Historically, it is always difficult to be negative on equity when Dividends are higher than coupons. Likely, European equity will be boosted by liquidity factors. Potential growth and better fundamentals will attract cash in Emerging and Frontier markets. The U.S. equity market will be clouded by the lack of clarity of the new administration, possible backlash between the Presidency and the Congress and divergences between the FED policy and the administration. Besides, U.S. equities are more expensive than European or Emerging markets, and a big part of the positive news flow is already integrated into the prices.
- Long emerging debt and inflation-linked
The low-interest rates environment in a developed market will not make fixed income attractive for long-term investors. They will look for diversification; the inflation-linked bond will attract some interest, even if inflation risk remains subdued. The improvement of fundamentals in most of emerging economies will bring in some liquidity with clear regional differences.
- Unchanged on commodity
The outlook is stable but clouded by a lot of geopolitical factors.
- Appetite for illiquid assets
The increase in uncertainties will be an argument for diversification but also for long-term investment.
- “Alpha generator” versus Beta
The level of uncertainties will push investors to pay a higher cost for creating value, looking for Alpha generator rather than pure Beta as ETF or passive fund.
- Buy Volatility
The current level of the market volatility remains relatively and historically low (the VIX contract is around 14%).